1 Reducing Risk: Insurance

14.01 Principles of Microeconomics, Fall 2007

Chia-Hui Chen
September 28, 2007

Lecture 10

Insurance and Production Function Outline

1. Chap 5: Reducing Risk: Insurance 2. Chap 6: Outline of Producer Theory 3. Chap 6: Production Function: Short Run and Long Run

Reducing Risk: Insurance

Diversication Insurance Example (House insurance). Assume that one house has the proba bility p to catch re, with loss l each time, i.e. the owners wealth will reduce from y1 to y2 = y1 l. If the owner pay premium k to buy an insurance which covers the loss l when there is a re, her wealth will be y3 = y1 k , for the situations listed (see Table 1). No Insurance y1 y2 = y1 l Insurance y3 = y1 k y3 = y1 k

Reducing Risk:

No Fire Fire

Table 1: Wealth of House Owner in Dierent Situations. Assuming the owner is a risk-averse, the utility function is concave. u (y ) < 0

If the expected wealth at both situations is equal, y3 = (1 p) y1 + p y2 . We have

k = p l.

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1 Reducing Risk: Insurance

Figure 1: The Utility Function of Risk Averse Person.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

1 Reducing Risk: Insurance

The insurance premium is equal to the expected payout by the in surance company, and we say the insurance is actuarially fair. Since the person is risk-averse, u(y3 ) > (1 p) u(y1 ) + p u(y2 ). she will choose to buy insurance. If the insurance is actuarially unfair, k > p l. Then y3 < (1 p) y1 + p y2 . We do not know if the person wants to buy or not until we get her specic utility function, but it is easy to imagine she may buy insurance if k is close to pl. Now we consider what is the maximum insurance premium that the companies can charge and the costumer is still willing to buy the insurance. In this case, let y3 be the house owners wealth after being charged the maximum premium. Then, (Figure 1)
u(y3 ) = pu(y2 ) + (1 p)u(y1 ).

Thus the maximum insurance premium charged is

k = y1 y3 = y1 E (y ) + Risk P remium = p l + Risk P remium

So are insurance companies more willing to take risk? If not, why are they willing to sell insurance? The Law of Large Numbers can explain this. Let L be the total loss from n customers, It is a random variable. L The average loss shared by each customer is L n , and E ( n ) = n p. The expected payout for L by the insurance company will be E (L) = n p l When n The probability that the loss shared by each customer is equal to a xed number pl is almost 1. (Figure 2) L = p l) n 1. n Note that this argument only applies to the situation when customers
re accident events are independent.
Example (Illegal parking). Government has two reasonable methods
to punish illegal parking.
Hire more police, get caught almost for sure but ne is low. Hire less police, get caught sometimes but the ne is high. The latter might be more eective since people are risk averse abd are afraid to take risk of being ned to park illegally. P robability (
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

1 Reducing Risk: Insurance

Figure 2: Distribution of

L n

with Dierent Customer Numbers.

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2 Outline of Producer Theory

2 Outline of Producer Theory

Production Function: Inputs to Outputs Given Quantity Produced, Choose Inputs to Minimize the Cost Choose Quantity to Maximize Firms Prot The Production Function is q = F (k, L). The two inputs: k : Capital L: Labor It is easier to change labor level but not to change capital in a short time. Short run. Period of time in which quantity of one or more inputs cannot be changed. For example, capital is xed and labor is variable in the short run. Long run. Period of time need to make all production inputs variable. In the long run, both capital and labor are variable.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].